WEEKEND ECONOMIST: Fixated on US unemployment

Westpac expects the US economy to grow at low levels with high unemployment in the next few years, but if the sharp improvement in the unemployment rate extends, it could have dire consequences for bond and currency markets.

Over the last two weeks I have been travelling in the United States visiting hedge funds, real money managers, corporates and officials.

The area of most interest from my perspective has been the outlook for US policy which, of course, will be dependent on the state of the US economy.

Following the two-day meeting of the Federal Open Market Committee (FOMC), on January 24 and 25, the committee adjusted its guideline for policy to state that it intended that "economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014". This represents an extension of the "exceptionally low" period by around one year.

The FOMC has also dramatically increased its transparency by providing forecasts of real gross domestic product (GDP) growth, the unemployment rate (average of the final quarter in each year), personal consumption expenditure (PCE) inflation and the federal funds rate for 2012, 2013 and 2014. The distribution of the individual forecasts for the 17 members of the committee (five governors and 12 district presidents) is also provided. In addition, the assessments of the 'longer run' levels of these variables is also provided.

Information on the 'longer run' levels for the federal funds rate and the unemployment rate is particularly important. FOMC member assessments of the longer run unemployment rate has a range of 5.2 per cent to six per cent while the longer run federal funds rate is in the four to 4.5 per cent range. The longer run growth rate is in the range of 2.25 per cent to 2.75 per cent while, not surprisingly, the longer run inflation rate is on the 'target' of two per cent.

We can interpret this 'longer run' concept as a view on equilibrium levels: i.e. four to 4.5 per cent for the federal funds rate; 2.25 per cent to 2.75 per cent for growth; 5.2 per cent to six per cent for unemployment; and two per cent for inflation.

We can then use these to draw some inferences from current FOMC forecasts. With respect to the federal funds rate, there are six forecasters who expect it to still be in the zero per cent to 0.37 per cent range by the end of 2014. While not identified, it is reasonable to assume these are the same six forecasters expecting the unemployment rate to be near 7.6 per cent to 7.7 per cent (the highest in the survey) by the end of 2014.

On the reasonable assumption therefore that even the most dovish forecasters expect to begin normalising policy in 2015, it is sensible to conclude that once the unemployment rate reaches 7.6 per cent to 7.7 per cent there would be a unanimous view within the committee in favour of beginning the policy normalisation process.

That assessment seems reasonable given the critical insight that the committee sees the 'longer run' as unemployment in the 5.2 per cent to six per cent range and the federal funds rate in the four per cent to 4.5 per cent range.

The FOMC forecasts currently envisage a very slow improvement in the unemployment rate. For growth in the 2.2 per cent to 2.7 per cent range in 2012 the unemployment rate (which at the time of the meeting was 8.5 per cent) was expected to fall to 8.2 per cent to 8.5 per cent by years’ end; growth of 2.8 per cent to 3.2 per cent in 2013 was expected to see a further fall in the unemployment rate of 0.4 to 0.8 percentage points (ppts); while growth of 3.3 per cent to four per cent in 2014 would see the unemployment rate fall by a further 0.7ppts.

This 'sedate' fall in the unemployment rate stands in contrast to the recent facts. Over the course of 2011 the unemployment rate has fallen from 9.4 per cent in December 2010 to 8.5 per cent in December 2011; or from 9.1 per cent in January 2011 to 8.3 per cent in January 2012.

Over the course of 2011 GDP growth was 'only' 1.7 per cent – that is, a fall in the unemployment rate of 0.8 to 0.9ppts was achieved with a growth rate of one to two ppts less than that envisaged in the FOMC forecasts.

As widely noted, the speed of the decline partly reflects a sharp fall in workforce participation rates. There is ongoing debate about the fall in the participation rate and the potential for a reversal if 'discouraged workers' return in response to sustained jobs growth. This could significantly restrain the future pace of reductions in the unemployment rate. Supporting this view is the extensive evidence of workers moving onto permanent disability benefits rather than returning to lowly paid jobs in the workforce once their unemployment benefits run out.

But even on the basis that about half of the fall in the unemployment rate in 2011 was due to a drop in participation, that still leaves a 0.5ppt fall in the unemployment rate that would surprise the Fed. Note that growth in 2011 was 1.7 per cent only slightly above the Fed's 'stall speed' estimate of 1.5 per cent, an annual pace typically only seen in recessions and associated with a rising unemployment rate.

Others question the employment data arguing that income, spending, and output data are not strong enough to be consistent with the jobs growth (an exception is likely to be business conditions indexes, which have been quite robust).

However there is also the possibility that the structure of the US labour market has changed, particularly following recent the sharp increases in labour productivity, falls in real wages, and increased job flexibility, which have made the return/cost balance of additional employment more attractive to firms.

We have sympathy with all these arguments, but our central view remains that the ongoing growth profile and job creation will be soft.

There is also the possibility that the FOMC could lower its 'longer term' estimate of the unemployment rate – thereby accommodating a more rapid improvement in the labour market without needing to adjust the policy outlook. There was some hint of that in the chairman's testimony to Congress where he indicated that the Fed controlled inflation, but could not do the same for unemployment.

However we cannot ignore the risk to markets if this unexpectedly rapid improvement in the unemployment rate continues. Recall that the January meeting of the FOMC occurred before the release of the January employment report, which showed the unemployment rate falling further from 8.5 per cent to 8.3 per cent.

The chairman's rhetoric at the subsequent Humphrey Hawkins testimony was much less encouraging with respect to the prospects for QE3 than it was in his press conference following the January FOMC meeting.

The FOMC's 'central tendency' forecast from its January meeting has the unemployment rate in the fourth quarter of 2012 at 8.2 per cent to 8.5 per cent. How that changes in light of the January jobs report and how the labour market data unfolds in coming months will clearly be crucial guides to the policy outlook.

A further complication for the Fed is around fiscal policy. Its central tendency forecast for growth in 2013 is around three per cent. However, if unadjusted,fiscal policy is set to subtract around 2.7ppts from growth in 2013 (see Table 1). Any change in its monetary policy stance might be delayed until the Fed sees some more clarity on the fiscal front.

This situation places significant importance on the employment reports over the next three to six months. If we continue to see further improvement in the unemployment rate, markets may start to focus on the need for the FOMC to bring forward the likely timing of the end of the "exceptionally low" rate period. While pushing that date back, as we saw in January, helped lower rates even further, it is daunting to envisage how markets would react to a 'bring forward' announcement.

At the very least, such an event is likely to be extremely unsettling for markets. A flight to the US dollar and a move out of risk assets is most likely. Ironically, as we look to Europe for the next 'risk off' event another possible candidate could be the US itself.

While recognising these risks we are retaining our central view of 'sub two per cent' US growth over the course of the next few years with limited improvement in the unemployment rate; an extended period of "exceptionally low" rates and, in due course, the need for QE3. However this note does highlight the potential risk to bond and currency markets that would result from an extension of the recent sharp improvement in the unemployment rate.

I expect that there will be even more than usual interest in the next employment reports in the US.

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